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Thursday, June 22, 2017

David Skilling: Just when you think it’s safe

One year on
from the Brexit vote in June 2016, the UK is going around in circles with no
political consensus on how to approach the negotiations – or even what they
would like to achieve. There is not a sufficiently large constituency for
the hard Brexit approach seemingly favoured by PM May. This opens the
door for a softer, more pragmatic Brexit, with lower economic costs – but also
raises the odds of the UK crashing out of the EU with no deal.

But
relative to the concerns that were held in the shocked aftermath of the initial
Brexit vote, the fallout has been localised.

The most obvious casualty
has been the GBP: it fell by 11% against the USD on the day of the Brexit vote;
and has weakened again over the past week in response to renewed political
uncertainty. And although the FTSE 100 is up on the back of accommodating
monetary policy from the Bank of England and the low pound, there has been a
hit on stocks that are domestically focused. There are also signs of
Brexit costs beginning to manifest in the UK: lower consumption spending,
reduced business investment, and some relocation of activity away from the UK.

But these
effects have not radiated very far. Ireland was in the firing line, as an
economy highly exposed to the UK. In the weeks after the Brexit vote, the
Irish equity index was down as much as 14% from pre-Brexit levels.
However, it recovered these losses by December and the index was up by about
10% in the year to June 1. Although Brexit remains a serious strategic risk to
Ireland, so far the economic and market impact has been relatively
modest. And Ireland is running a successful campaign to attract
investment and jobs that are relocating from the UK. Other UK-exposed
economies, such as the Netherlands or some of the Nordics, have a similar
experience. Further away, in Asia for example, it is hard to discern a
Brexit effect in equity markets. Brexit is an act of strategic self-harm, with
localised effects, rather than a systemic event.

Indeed, the
absence of evident systemic effects has been a consistent story over the past
12 months of heightened political risk around the world. To paraphrase
Robert Solow on the productivity impact of IT, you can see political risk
everywhere except in market pricing or economic data.

The
combination of the Brexit and Trump votes in 2016 generated serious concern
that the liberal, rules-based system was under threat. Protectionism and
populism were seen as making a comeback as public opinion seemed to turn.
But the unexpected Trump victory was received by a substantial market rally – as
investors focused on expected fiscal stimulus and tax reform. And GDP
growth was strong through 2016, as emerging markets picked up.

This was
also the case in small advanced economies around the world, the group of
countries that I monitor to provide early, clean insight on the changing global
economic and political system. Small economy markets have performed in
line with key equity benchmarks over the past 12 months, like the S&P 500
and Euro Stoxx 600. Although the small economy equity rally was not as
pronounced as in large economies after the Trump election, there has been a
convergence through 2017. This convergence has been assisted by the
reduced political risk and uncertainty in Continental Europe, after elections
in France and the Netherlands. And some of the largest concerns have not
yet manifested: there have not been major instances of protectionism or
currency tensions, for example. And even TPP has better odds of survival
(without the US) that had been thought possible a few months back.

In general,
the response of equity markets in small economies suggests an absence of
perceived systemic risk in the global economic and political system. The
concern that we were ‘present at the destruction’ in 2016 seems, on this
evidence at least, to have been overdone. Small economies are acutely
exposed to changes in global system; the relatively strong economic and equity
market performance of these economies suggests the absence of systemic
effects. Much of the impact of change, from Brexit to NAFTA renegotiations
and European populism, has been localised. For example, the GBP after
Brexit, French equities after Mr Macron, the Mexican peso in response to Mr
Trump, and so on.

But this
equity market and economic performance contrasts sharply with the assessment by
highly exposed small economies of the risks to the global system. The risks of
a more closed global system and the return of big power politics remain issues
of high concern in small economies. These concerns about the outlook are
perhaps better reflected in small economy bond markets, where a persistent gap
has opened up between small and large economy government bond yields.

Indeed,
events over the past month suggest that we should not relax. The repeated
unwillingness of the US to agree to statements rejecting protectionism at the
G7 and the OECD, weakens the system; as does its unilateral withdrawal from
multilateral agreements (TPP, Paris Agreement) and its behaviour with respect
to allies (from NATO to Qatar). This undermining of global and regional
institutions and norms matters, making it harder to contain tensions when they
arise.

And there
are several areas in which these political risks are beginning to take concrete
form. The possibility of new protectionist measures by the US (on steel,
for example) may attract retaliation; the tensions between China and the EU on
whether to agree to market economy status for China at the WTO could affect
many other elements of the relationship (notably agreement on emissions
reduction, but also trade and investment); and the increasingly assertive
behaviour of China in East Asia is challenging the rules-based system. In
this context, new shocks – be it in Asia, the Middle East or the Eurozone –
will be increasingly difficult to manage.

This is an increasingly
challenging global context to navigate, and particularly for small advanced
economies. Just as fatalism on the future of globalisation was
inappropriate in 2016, so now complacency about the outlook should be
avoided. Although markets seem to have largely discounted systemic
political risk, perhaps as in the movies, just when you think it is safe – it’s
probably not.

Dr David Skilling, the Director of the Singapore-based Landfall Strategy Group, was formerly the Chief Executive of the New Zealand Institute and before that, a Principal Advisor at the New Zealand Treasury.

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